The precipitous de-cline in the small-capitalization mining sector over the past few months is yielding some bargain-basement prices for companies with top-quality projects. But mining analysts are suggesting you proceed with caution — if at all.

“As long as the [large-cap] producers are relatively cheap, that’s the safer place to be if you want to be in the mining space,” says Stefan Ioannou, an analyst with Toronto-based Haywood Securities Inc. “The producers have been beat up, but, at least, they are still generating cash flow. So, they don’t have any imminent bankruptcy risk.”

It’s a different story for the small-caps. As they have no source of revenue, only those companies with strong management, rich treasuries and top-quality projects are likely to survive the rout. And even these companies are vulnerable if the bear run has staying power beyond a year or two. Both debt and equity financing taps have been shut off and will not open again until some stability returns to the markets.

If the previous two downturns in the junior mining sector are any indication, it could take a while for stability to return. Following the market crash of 1987, for instance, the speculative market (then the Vancouver Stock Exchange) declined by about 75% over the course of almost four years. A decade later, in 1997, the Bre-X Minerals Ltd. scandal triggered a sell-off in junior mining equities that resulted in a 73% decline over the next three and a half years, according to a research report on the small-cap mining sector by Vancouver-based Canaccord Adams Inc., the global capital markets arm of Canaccord Capital Inc.

On the other hand, the current downturn — which has seen the TSX Venture Exchange fall by 75% from its peak in May 2007 — could be seen as a steep correction in a cycle that will resume its course once sentiment toward global growth improves and China, in particular, continues its expansion and consumption of base metals. (About half of the companies that trade on the TSXV are junior mining companies.)

“In our investment thesis,” states the Canaccord research report, “we postulate the potential for a short consolidation period and quicker recovery in the current market environment than we have observed in previous cycles.”

In that case, small-cap equities with good development projects could enjoy a strong recovery over the next six to 18 months if they pursue exploration and development programs with prudence. “Within that period, we are hopeful a good defence leads to the best offence,” the report continues, “and an off-the-bottom rally provides substantial returns for risk-tolerant investors.”

The likelihood of a quick rebound for the small-caps will also depend on their commodity of interest. The direction of the price of gold is difficult to gauge because the precious metal is often driven by investment demand. A strong reflationary environment could work in its favour. But gold has not traditionally performed well during recessions. Zinc and nickel prices are already at levels at which many projects and operating mines are uneconomical and are being closed, setting the stage for a price rally. Copper, however, could have further to fall as demand continues to weaken.

“Twenty-five per cent to 50% of zinc producers are uneconomical right now,” says Ioannou. “They are either slowing down operations or putting them on care and maintenance. That is going to restrict supply over the near to medium term and affect the price. Copper projects are still marginally economical, so there is still room for copper to come down further.”

An Oct. 20 Haywood research report has trimmed its long-term (to 2012) copper price assumption to US$2 a pound from US$2.50 a pound, with a corresponding reduction in target prices for the copper development companies that it covers.

Nevertheless, the report calls the current market weakness as an opportunity to go “bottom fishing” among the base metal companies that are most likely to see their projects developed — many of which are trading below their intrinsic cash value.

The Haywood report’s clear favourite is Toronto-based Nevsun Resources Ltd., which has US$58 million in cash on hand to develop the Bisha gold/copper/zinc project in Eritrea. Nevsun has completed a feasibility study, secured a mining licence and is on track to begin production in mid-2010. Its shares were recently trading around 65¢ each; the report’s target is $2.75 a share.

These selections are concentrated in gold, silver, copper and uranium. B2Gold, Colossus, Exeter, Lake Shore and Rainy River all have advanced gold projects; MAG, Minera Andes and Silverstone are silver plays. Fronteer has a broad portfolio of uranium, precious metal and copper assets, while Northern Dynasty’s main asset is the Pebble copper/gold/molybdenum deposit in Alaska. Hathor and Ur-Energy are both uranium plays.

The catalyst for a reversal in the current small-cap downturn could take several forms, says the Canaccord report. If the TSX rallies in any sustainable way, excess cash should start trickling back into the TSXV. More mergers and acquisitions — such as the recent takeover of Aurelian Resources Inc. by Toronto-based Kinross Gold Corp. — could also attract attention to small-cap miners that are viewed as takeover targets. Another traditional trigger for a junior rally is a discovery, such as Toronto-based Noront Resources Ltd.’s nickel find west of James Bay, which lifted the share prices of all the juniors exploring in the area in late 2007.

One of the dangers juniors with high-quality projects face is being swallowed by cash-rich majors before they have a chance to recover from the recent battering.

“I’d be surprised if many of the majors aren’t doing their homework right now on some of the better [junior] development projects,” Ioannou says, “because they are going to be able to pick them up for bargain-basement prices. It’s a no-brainer exercise to take out these companies that are strapped for cash while their valuation is low, if they have a good project technically that, as a major, you can finance.”

The Canaccord report remains optimistic about the supply/demand fundamentals for metals while recognizing that investors are shunning the risky small-cap sector. Continuing strong demand for metals from the developing economies of China and India, for instance, could offset slowing demand elsewhere, while the constraints of high capital costs, limited credit, and political and environmental challenges will put a lid on supply.

“Will the current global economic slowdown just set up the next wave of the current super-cycle for metals?” the Canaccord analysts ask in their report. “Possibly, and time will tell.”

It appears that certain names in the junior mining sector offer fundamentally good value right now. The decision for your clients will come down to how much risk they are willing to shoulder while markets are unstable — and, of course, how long they are willing to wait for the rewards. IE